July 11, 2012
To ensure that your emergency fund (short and long) serves you to the best of its ability, it should include certain key components, mainly accessibility, liquidity and low/no risk. Let’s examine what each of these mean so that you know how to maximize your fund’s protective potential:
The nature of an emergency fund basically implies that this is a chunk of money that you will need to get your hands on as soon as possible, in the event of an unpredictable, unavoidable expense. If your car breaks down unexpectedly and you have no means of getting to work until your car is repaired, you’re going to need the cash to cover this cost immediately—waiting two days for the bank to open after a weekend and then sitting around for another few days while the bank processes your request to access funds from your online savings account simply won’t work.
This is where the benefits of having both a short- and long-term emergency fund become apparent. A short-term fund will allow you immediate access to your money and can be used for smaller, but still important financial crises, or as a source of cash to provide for you until you are able to access the money in your long-term fund. To maximize accessibility, always have cash available and ready for use (i.e. stored in a home safe, or hidden in a secure place anywhere you might be when an emergency comes up, like in your car, at work and/or an alternative location in your house); you should also have a debit card on you at all times and (if possible) have authorization to write checks for the money in your short-term fund. Armed with these precautions, you will be able to get to your money whenever and wherever you want.
An emergency fund’s liquidity is defined by its ability to be easily and rapidly changed over from asset to cash. Many people allocate their wealth to a number of different vehicles, each serving different purposes, with their own advantages and disadvantages, depending on an individual’s unique financial situation. For instance, your checking account would be considered 100% liquid because it is already in cash form. Stock shares, however, must be sold before you can use them for their value, and depending on the market, this can be less (or more) then it was worth when you initially purchased it, which can impact your ability to sell the share.
This doesn’t necessarily mean that all cash assets will have the same ease of liquidity—they can cause difficulties too. Certificate of Deposits (CDs) are one example of this; there are penalties associated with early cash withdrawals from these, and some are more severe than others, depending on the CD. If you plan on using a CD as an asset to be included in your emergency fund, it is a good idea to allocate this to your long-term emergency fund, and always make sure you understand the penalties involved.
When choosing an account to keep your emergency fund in, you’ll want to go with one that carries little or no risk. This type of account helps guarantee that the fund is secure in its ability to provide for you in the event of an emergency; on the down side, it also means that it will accrue very little interest, as the rate of return on investments is typically commensurate to their risk level. Top candidates for this type of low/no risk account include checking, savings and money market accounts; CDs and on-hand cash will also satisfy this requirement. Regardless of which one you decide to go with, it is essential that the accounts and/or investments that are tied to your financial institution are covered by FDIC insurance.
Some individuals have chosen to go with investment instruments like Treasury bills, notes and bonds as another low/no risk option, but the security once associated with government-issued instruments has been brought under scrutiny and therefore may only be valid for their low risk, not their guarantee.
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